"It Depends" A Problem with an IRA Account
by Paul Paulson, moneykeg.com. May 4, 2006
There are some circumstances that undoubtedly arise from being the "educated" member of a family. Education has often been a double edged sword since, you expended time and effort in acquiring the knowledge, and now you must DO something with it. I think it was Napoleon Hill who said something to the effect "the educated man is the man who can acquire what he wants without violating the rights of others." This definition however, is not shared by the majority of the public. Instead, a degree of some sort is a standard definition of education.
I assume that most, if not all, attorneys go through a "rites of passage" where new members of the bar are bombarded by the most complicated legal questions a layperson can dream up. Of course, the answers mostly begin with the phrase, "It depends. . ." Yet that does little to lessen the volume of questions. What they do not realize is that a law student is not taught every law that exists. Such a requirement would undoubtedly violate the US Constitution's 8th amendment against "cruel and unusual punishment". What law students are taught is how find and interpret laws. This is the skill that begins in law school and is refined in practice.
Another fortunate/unfortunate occurrence in the young professional's life is the responsibility of handling all legal matters that arise for friends and family. This is fortunate in that the young attorney gets a fresh batch of cases. It is unfortunate because expectations are high and almost all matters are done gratis. Nevertheless, the attorney, as the only family member "qualified" to handle such matters is sent off to find justice. He is deemed the "family lawyer".
In addition to the above, I have also the experience of being the family "financial expert". This role, however, I volunteered for, as I saw the family's wealth unprotected on several fronts. Like attorneys, advice is requested only after a problem is noticed. My experience with my father's finances is no exception.
My dad worked for decades as a hospital administrator at a facility built for a large international union. Over time, he had amassed several hundred thousand dollars in his pension. Several years ago, the hospital embraced managed care and the hospital was closed, forcing much of its employees into retirement or other ventures.
Being between the ages of 59' and 70', and in no real need for large withdrawals, my father's account has been sitting mostly in cash for the last several years. In his mind, I suspect similar to many of his contemporaries, cash is as safe an investment as there is. Several years ago, I began to dissect this mind set. It seems to me, under current economic conditions, nothing can be further from the truth.
Essentially, an IRA is an investment account designed to take advantage of compounding gains in a tax-deferred vehicle. The gains, (assuming there are any) are not taxed on a yearly basis but are allowed to grow tax-free until distribution. 401K's are also cut from this cloth. This is basic stuff. What is not basic is the staggering amount of problems when trying to manage these accounts.
These types of accounts (SEPs, IR's, 401Ks, pensions, etc.) are all designed with the financial institution or "custodian" in mind. The "strategy" calls for continuous contributions, for a period of years, with no distribution until age 59 - without a penalty. The account holder gives up virtually all control over the account during this time. Not just withdrawals, mind you, but also in the investment strategies allowable under the current rules.
It should come as no surprise to readers of this article that inflation is as rampant as ever and with little hope of subsiding any time soon. Perhaps, the Fed has only two cards left in its deck. Either it concedes that it is part of a bogus system, or it inflates away the current economic imbalances and blames the resulting chaos on an ancillary cause. Most gold bugs are betting on the latter. Herein lays the problem with retirement money.
How to extract money out of an IRA in the most cost efficient manner possible, realizing the following:
- All distributions are taxed as ordinary income,
- Inflation is eroding the purchasing power of the dollar,
- The impending global economic imbalances create a severe risk of systemic breakdown, making time an important variable.
- In light of the foregoing, certain hedges against inflation, namely, gold and silver are in a major bull run and show no signs of breaking down in the near future.
Since a person's wealth is measured by how much capital he possesses relative to the possession of others, it stands to reason that a person can become rich by default. That is, by protecting his wealth when all around him are losing theirs. With this in mind, gold and silver plays have been promoted by gold bugs for years. How to play precious metals in a retirement account however, is a challenge, even for professional advisors.
I refer you to the following page, (IRS)
There you will find a list of prohibited transactions and also a list of exempt transactions (those not prohibited under law). For example, borrowing money from your IRA is not allowed. Neither is selling property to it, receiving unreasonable compensation for managing it, using it as security for a loan, or buying personal property for personal use.
Also, investment in certain collectibles (art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and "certain other tangible personal property") will trigger a 10% penalty under current rules. The exemption for this rule is investment in:
"one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion."
At face value, this seems like a great break. That is, you have a chance to invest in precious metals within the account. Of course, there is a catch. In fact, there are several.
First, in order to open an IRA, you must sign a custodial agreement with a financial institution. What this agreement does is set up the rules the account's custodian requires before it takes on the job of managing your assets. Within the agreement, the custodian, at its discretion, can prohibit certain transactions.
You must keep in mind that these products were designed by financial institutions for financial institutions. They (the financial institutions) want your money in the markets. They want your money in funds, stocks, bonds and various other paper assets. The reason for this is profit, pure and simple. Since, it is unlikely a custodian profits from a piece of rental real estate or the storing of physical metal, they specifically exclude these types of investments from your IRA. Other excluded types of investments (depending on the institution) are futures contracts, real estate and physical bullion. Of course, you can still invest in mining stocks, ETF gold and silver, REITs and the like. The financial institutions profit from these.
Other investment strategies are also excluded by many custodians. Techniques such as purchasing call and put options, straddles, swaps, and many others are unavailable to the IRA account holder.
Precious metal ET's, mining stocks and similar assets make the US Government your partner if the assets are kept in this account. Further, if your outlook on the economy is bleak, and you understand the risk of economic breakdown, then you probably want to take possession of physical gold and silver. The options allowed within the IRA will likely not ease your anxiety since the above choice of gold/silver plays still fall into the realm of paper assets. And, in the event of economic collapse, all bets are off. One would be naïve to think that they could convert their paper into physical after a collapse had commenced.
Therefore, perhaps the safest way to protect against a cataclysmic economic event would be to extract the money from the account and take delivery of physical metal. Another problem with the IRA account, then, is taxes.
Let us assume you are amenable to the above withdrawal strategy. How much money should you withdraw, when should you do it, and what is the break even point?
Here comes that answer again - "it depends". What it depends on is the following:
- Price projections
- Current tax rates
- Current income
- Rate of inflation
- Timing of the withdrawal
I took the time to include a remedial excel spreadsheet to calculate these variables. The following is a conservative estimate of what it would take to break even, using the "withdraw and pay taxes" strategy.
The spreadsheet defines the current gold price of $670 and an inflation rate of 6%. This is what it revealed:
|Withdrawal||Tax Rate||Inflation Factor||Tax||Gold Price||Gold Increase to B/E||B/E with Inflation||Tax PP|
Keep in mind, this calculation does not take into account the lost opportunity on taxes paid. But it does calculate the loss in Purchasing Power on the taxes paid (Tax PP); the break even point for a gold increase (Gold Increase to B/E); and the amount those same dollars are worth in terms of purchasing power relative to gold (B/E with Inflation). Unless my calculations are wrong, then a withdrawal of $100K will require a $22,500 tax payment which could be offset if the price of gold were to reach $820.75 and that price was realized. Theoretically, one could then sell some gold, pay the tax debt and be free from the IRA and its restrictions. The B/E with Inflation calculates what that same $820 (gold price per ounce) buys in future dollars and the Tax PP describes the purchasing power of the dollars paid to Uncle Sam.
This analysis however, does not result in a "no-brainer" strategy. The account holder must decide a course of action since there are still some variables in play. One such variable is when the money will be withdrawn. The above calculations were made in April so that it is easy to calculate the inflation rate on an annual basis. Obviously, if withdrawal occurs in December, that will change the scenario. Also, the above calculation assumes no other income earned during that period. And perhaps there are still more variables missing from the scenario.
Nevertheless, the above gives a broad sketch of the situation. It is up to the individual to come to his/her own conclusions.
Personally, I will have a hard time convincing my father, the true account holder, to write a $100,000 check to the IRS. I do not blame him. I fear that I will have to preach the dangers of fiat currency until I am blue in the face before he realizes what I am saying. Oh well, that is the job of any family financial "expert".
Thanks for listening.
DISCLAIMER: This writing is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.
© 2006 Paul Paulson